CBA: GDP above-potential growth and its non-widespread nature poses  uncertainties regarding relative position of aggregate demand versus  aggregate supply

ArmInfo.The persistence of above-potential growth, as well as the non-widespread nature of  recent growth, poses certain uncertainties regarding the relative position of aggregate demand versus aggregate supply.

This was stated by head of the Central Bank of Armenia Martin Galstyan, presenting at  a press conference on June 11 a detailed justification for the decision to once again reduce the refinancing rate by 0.25 percentage points - from 8.25% to 8%. According to him, on the one hand, growth  remained strong and above long-run potential, which could suggest  excess demand conditions. On the other hand, the concentrated and  non-widespread nature of recent economic growth could speak to weak  consumption and suggest a closed, or even negative, output gap.

As the Executive Monetary Policy Statement published by CBA on its  official website reads:

"In the second quarter of 2024, risks of slowing economic growth  globally and in the key trading partner countries of Armenia continue  to persist. Global inflation continues to decline, but sticky prices  continue to remain relatively elevated in key trading partner  economies. At the same time, overheated labor market conditions  continue to contribute to sustained high demand conditions in key  trading partner economies. Geopolitical tensions in the Middle East  since the beginning of the year, as well as growing tensions in  international trade relations, continue to create risks for future  growth in global commodity prices and potential disruptions in global  supply chains. In this context, it is likely that key trading partner  central banks, and in particular the US Fed, would maintain tight  monetary conditions for longer. Consequently, weak deflationary  effects from the external sector on the Armenian economy would  persist.  Economic activity in Armenia remained robust in the second  quarter, continuing to be largely driven by meaningful growth in the  construction, trade, and industry sectors. The latter continues to be  impacted by certain short-term factors, posing significant  uncertainty with respect to the sustainability of economic growth and  its long-term outlook, as well as the strength of domestic demand and  consumption conditions. External demand for domestic services  continues to slow relative to 2023. At the same time, risks for  modest demand pressures stemming from fiscal policy continue to  persist. The inflationary environment in Armenia continues to remain  low, driven by the monetary policy implemented by the CBA in recent  years, weak deflationary pressures from the external sector, and  somewhat weaker aggregate demand conditions. Further, labor market  conditions continue to cool somewhat, reflected in cooling wage  growth as well as declining non-traded sticky price inflation and  inflation expectations.  In the face of high uncertainty, and given  its commitment to achieving the price stability objective, the Board  considers multiple scenarios during its deliberations.  On the one  hand, the Board discussed scenarios where possible underlying  developments-including persistently tighter monetary conditions in  key trading partner countries, as well as uncertainty related to the  country risk premium and neutral interest rates-would require a  higher path for the policy rate relative to current market  expectations in order to manage risks that threaten the price  stability objective. On the other hand, the Board discussed scenarios  where potential economic developments-including the risk of weaker  demand conditions emerging, given certain structural features of  economic growth-would cause inflation to persistently remain at a low  level. This would imply a more rapid and aggressive downward path for  the policy rate than what is currently priced in markets in order to  sustainably bring inflation back to target in the medium-term  horizon," Executive Monetary Policy Statement reads published by CBA  on its official website.  "

In its Summary of Economic Conditions CBA outlines :

 Global Economy In 2024Q2, economic activity among Armenia's main  trading partners has been mixed; however, risks of weaker economic  activity going forward continue to persist. Despite an elevated  policy rate in recent quarters, the US continues to experience strong  growth, spurred by persistently robust consumption and domestic  demand conditions. Amid these conditions, headline inflation, sticky  prices, and wage growth all remain meaningfully above their target  levels, complicating monetary authorities' task of finding a  sustainable path back to the inflation target. Moreover, the  persistence of these excess demand conditions raises questions about  a potentially higher underlying neutral rate in the US, with  implications on both the future stance of Fed policy and capital  flows to emerging markets. In the Eurozone, economic activity  continued to rebound in Q2, driven primarily by services, though  risks of economic slowdown still persist, particularly given the  structurally weakened position of industry and manufacturing in key  economies. These risks, as well as concerns related to the stability  of the real estate market and financial system in China, continue to  remain key sources of uncertainty driving a weaker global economic  outlook. Meanwhile, the Russian economy continued to experience high  growth and strong domestic demand conditions, despite the tight CBR  policy stance. However, the sustained imposition of stricter and more  targeted Western sanctions continues to pose risks to the medium-term   Russian economic outlook.  The overall inflationary environment in  the global economy continues to remain weak, though important upside  risks exist. Heightened geopolitical tensions in the Middle East,  which show few signs of easing, continue to threaten both higher and  more volatile energy prices as well as potential disruptions to  global supply chains. Food prices continue to remain below the high  levels of the previous two years, though consecutive month-on-month  upticks could suggest that further deflation in global food prices  may be drawing to a close.  Domestic Demand Conditions Economic  growth in Armenia in Q1 2024 remained well above estimates of  long-run sustainable growth (approximately 5%), comprising 9.2% Y-o-Y  growth. However, growth in Q2 was primarily concentrated in trade  (25.1% Y-o-Y growth), manufacturing (17.3%), and financial services  (17.2%) sectors. Economic activity followed a similar pattern in  April (Y-o-Y growth of 10.4%), though there was somewhat less  sectoral concentration of economic activity than in the first four  months of the year. The persistence of above-potential growth, as  well as the non-widespread nature of recent growth, poses certain  uncertainties regarding the relative position of aggregate demand  versus aggregate supply. On the one hand, growth remained strong and  above long-run potential, which could suggest excess demand  conditions. On the other hand, the concentrated and non-widespread  nature of recent economic growth could speak to weak consumption and   suggest a closed, or even negative, output gap.  

The robust external demand observed since 2022 has gradually weakened  by Q1 2024, as reflected in the stabilization of both real expenses  per tourist and tourist arrivals.  Meanwhile, considerable  uncertainty continues to surround domestic demand conditions. On the  one hand, the concentrated nature of recent economic growth would  suggest a relatively limited overall income effect; in this context,  the modest consumption growth seen in Q1 relative can be interpreted  as an indicator of somewhat weaker domestic demand conditions  emerging. This argument for weaker domestic consumption is further  supported by continued declines in remittances. On the other hand,  domestic demand could grow on the back of a reduced debt burden,  subsequent potential for credit growth, and previously accumulated  savings in the private sector. In this context, depending on how and  in which directions savings are used, they could have different  implications on the relationship between aggregate demand and  aggregate supply in the economy.  Additionally, risks for modest  demand pressures stemming from fiscal policy continue to persist.   The funds attracted and provided by commercial banks continued to  grow during Q1 2024, reflecting high economic activity. CBA surveys  of commercial banks further attest to sustained high demand for  loans. In recent years, the reduction in the debt burden (relative to  incomes) serves as a source of uncertainty in terms of the potential  for lending to accelerate and generate inflationary pressures.  

Labor Market & Inflation 

In the context of continued high economic growth, labor demand and  wage growth both continued to persist at high levels, with private  wage growth standing at 7.3% Y-o-Y in Q1 2024 and 4.5% in April.  While the growth in productivity and labor supply observed in prior  quarters continue to contribute to a weakening in inflationary  pressures stemming from the labor market, overall wage growth still  remains elevated relative to measures of headline and underlying  inflation. This could serve as a source for sustained inflationary  pressures to the broader economy. On the other hand, wage growth has  been somewhat concentrated in certain sectors, while other sectors of  the economy have seen slower or flat wage growth. This could be  interpreted as reflecting a meaningful weakening or neutralization of  inflationary pressures stemming from the labor market.  The potential  for further increases in labor supply could help ease labor market  conditions, moderating any potential inflationary pressures in the  medium to long term. In this context, the primary uncertainties  relate to the potential for a continued inflow of migrant workers to  the Armenian labor market, the rapid integration of forcibly  displaced persons from Nagorno-Karabakh in the Armenian labor market,  as well as slowing flows of Armenian labor migrants to Russia and  their greater participation in the domestic labor market.  

The deflationary environment has persisted in Q1 2024, primarily  driven by weakened pressures coming from the external sector, the  impacts of the CBA's policy stance over the past several quarters,  and somewhat weaker aggregate demand conditions. In this context,  overall CPI inflation has remained below target since April 2023,  standing at 0.3% Y- o-Y in May 2024. Non-Traded Sticky Price  Inflation, which captures domestically driven demand dynamics,  continued to stabilize, standing at 3.0% Y-o-Y in April 2024. At the  same time, inflation for services that are highly exposed to external  demand have also continued to soften, reflecting trends of slowing  demand. Nevertheless, in this context, there is still considerable  uncertainty surrounding household inflation expectations, which   continue to remain relatively elevated.  

Monetary Policy 

Market expectations of the CBA policy rate path have not changed  materially since the last decision and continue to reflect  expectations of a gradual reduction in the policy rate over the next  eight decisions. Since the CBA's previous policy rate decision, the  yield curve has slightly shifted downward. However, the downward  shift likely does not fully reflect market expectations about the  policy rate path, suggesting the sustained presence of certain risk  factors.  The country risk premium continues to remain at relatively  low levels, partly following trends in emerging countries. However,  some uncertainty persists regarding tensions on the state border,  regional geopolitical developments, and other factors; in this  context, an upward reappraisal of the country risk premium could pose  inflationary risks. At the same time, macroeconomic stability in  Armenia and high economic growth can serve as important preconditions   for a potential reassessment of the country risk profile.  

Considering the persistence of numerous types of uncertainty, the CBA  builds and evaluates several different scenarios for future economic  developments in order to manage possible risks stemming from these  key areas of uncertainty. The illustrative Case A scenario presented  in the MPR, where the policy rate path would need to be higher than  market expectations, is motivated by the risk of sustained  inflationary pressures from the US economy, driven by high domestic  demand there, as well as the threat of supply shocks amid global  trade and geopolitical risks. Amid persistently elevated demand  conditions, a potential upward revision to the neutral rate, and  continued negative supply shocks, the Fed would need to maintain a  tighter policy stance for longer. The implications on risk premiums  in emerging markets, including Armenia, could create preconditions  for capital outflows. To guard against the risk of nonlinearities  emerging-such as allowing depreciatory or inflationary pressures to  result in an upward ratcheting of inflation expectations-the CBA  policy rate path would need to adopt a tighter stance relative to   current market expectations.  

The illustrative Case B scenario presented in the MPR, where the  policy rate path would need to be lower than market expectations, is  motivated by the risk of a negative demand environment emerging in  the domestic economy. Specifically, specific structural features of  recent growth poses risks of resulting in relatively weaker  longer-term demand fundamentals. Over the medium term, these factors  could pose risks of more persistent deflationary forces taking hold.  In such a situation, the CBA policy rate would need to follow a  sharper and more aggressive downward path than what markets presently  expect, in order to stimulate demand and return inflation to the  target over the medium horizon.  

In the context of the latent risks and uncertainties in the current  period, the CBA builds and discusses various scenarios, summarized in  the Taxonomy of Scenarios, with the aim of managing possible risks  and assessing sources of uncertainty. At the same time, the MPR  includes a deeper dive into two illustrative scenarios, which reflect  illustrative future paths of the economy that would require either a  higher path for the policy rate (Case A) or a lower path of the  policy rate (Case B) relative to current market expectations. These  illustrative scenarios do not represent a most-likely future, assign  weight or probability to outcomes, or include all possible risks and uncertainties," the CBA concludes.